December 21, 2014
AnalysisMonday, February 3, 2014
Limits of capital controls are becoming evident
Restrictions on cash flows have limited success
When Argentina decided last week to ease limits on dollar purchases, it became the latest emerging-market nation to acknowledge that capital controls usually fail in masking an economy's flaws.
Argentina allowed the peso to plunge 15 percent after the Central Bank began scaling back interventions in the foreign-exchange market on January 22, spurring price increases of as much as 30 percent on consumer goods as international reserves fell to a seven-year low.
"Capital controls signal that a country is very worried about preserving its foreign exchange," Steve Hanke, a professor of applied economics at Baltimore-based Johns Hopkins University and an adviser to the Argentine government in the 1990s, said in an interview. "That means bad things are in the wind." The restrictions spawn illegal traffic in the local currency that creates "lying prices" in the economy, he said.
Restrictions on capital flows, ranging from Argentina's tax on vacations abroad to Malaysia’s stabilizing the ringgit after the 1997 Asian crisis, have had mixed results in boosting investor confidence in a country's economy. Capital outflow restrictions can be effective "if they are sufficiently comprehensive to slow a sudden 'rush to the exit,'" according to a report by four International Monetary Fund researchers released this month.
"For the average country, a tightening of outflow restrictions is ineffective as net outflows increase as a result of it," wrote Christian Saborowski, Sarah Sanya, Hans Weisfeld and Juan Yepez, authors of the IMF report.
In Venezuela, a decade of currency controls is fuelling the world's fastest inflation among the 114 economies tracked by Bloomberg and shortages of basic goods.
The official rate of 6.3 bolívars per dollar compares with the 75-bolívar rate on the black market. Official dollars therefore are the most profitable assets in the country, allowing people who have access to them enjoy a lifestyle far beyond the reach of an average Venezuelan.
"Capital controls to avoid excessive inflows have had limited success," Ricardo Hausmann, a former planning minister in Venezuela who now teaches economics at Harvard University, in Cambridge, Massachusetts, said in an e-mail. "Capital controls to prevent outflows often postpone and amplify rather than moderate the need for adjustment. If they involve an emergence of a black or parallel foreign-exchange market, they lead to a dangerous macro and micro disaster."
The IMF, influenced by then-US Treasury Secretary Robert Rubin and his deputy, Lawrence Summers, started to push Asian countries to open their financial markets and lift capital controls in the early 1990s. When the financial crisis started in late 1997, the IMF advised the region to cut budgets and raise interest rates to limit the currency depreciation.
Nobel laureate Joseph Stiglitz, then chief economist at the World Bank, opposed the IMF's remedies, pushing for capital controls to stem the crisis, advice no Asian countries except Malaysia took.
Malaysia, faced with global investors selling the nation's assets to bet on a depreciation in the ringgit, imposed restrictions in September 1998. These included making investors hold the ringgit proceeds of share sales for at least a year and banning the transfer of the local currency between offshore accounts.
The ringgit's real effective exchange rate stabilized the next year, after tumbling almost 20 percent, while the nation's foreign-exchange reserves gained following the biggest annual decline on record.
"The restrictions provided room for the authorities to accumulate reserves amid a stable exchange rate and enact policies aimed at revitalizing the economy, such as reducing interest rates," the Washington-based IMF researchers wrote in the report that examined capital outflow restrictions in 37 emerging markets from 1995-2010.
In Iceland, the krona exchange rate stabilized shortly after restrictions were imposed during the depths of the global financial crisis in November 2008. That gave officials room to ease monetary policy to help revive the economy, according to the report.
The IMF report concludes that capital controls can be successful if "supported by either strong macroeconomic fundamentals or good institutions, or if existing restrictions are already fairly comprehensive."
Cut in half
Since her re-election in 2011 when capital flight almost doubled to US$21.5 billion, President Cristina Fernández de Kirchner has made several attempts to keep money in the country. She implemented more than 30 measures, including blocking most purchases of foreign currencies, taxing online purchases, banning units of foreign companies from remitting dividends and restricting imports.
The controls cut the total amount traded last year in the local foreign-exchange market in half compared with 2010, according to data compiled by Argentina's Mercado Abierto Electrónico automated trading system. Still, the robust black market for dollars shows that some Argentines are finding ways around the controls.
The government also reduced some currency controls in place since July 2012, authorizing foreign-exchange purchases for people earning a monthly wage of at least 7,200 pesos U$S901. Those who qualify, less than 20 percent of the population, can buy as much as 20 percent of their average monthly salary, up to US$2,000 a month.
“The problem I see in the longer run for the capital control for outflows is that it interferes with foreign direct investments, because FDI wants to take money out of the country,” said Guillermo Calvo, an economist at New York-based Columbia University and former chief economist at the Inter-American Development Bank . “If a country develops that reputation, it can be very negative for FDI. That's very dangerous.”